The Precarious Fiscal Foundations of EMU

Written as European Monetary Union was getting underway, this paper argues that the Maastricht Treaty’s institutional design – an elaborately specified independent central bank paired with only vague, uncoordinated national fiscal rules – creates serious hazards once viewed through the lens of the fiscal theory of the price level (FTPL). Sims first lays out the FTPL’s core logic: the government’s flow budget constraint implies that the price level is pinned down by the ratio of nominal government liabilities to the present discounted value of current and future primary surpluses, a relation that exists alongside, but is analytically distinct from, the conventional money-demand relation between the price level and the money supply – neither equation determines the price level “alone,” only as part of a full general-equilibrium system. From this starting point Sims makes a series of points that reshape how central-bank “independence” should be understood: because new nominal debt commits the government only to future nominal, not real, revenue, unbacked debt issuance dilutes the value of existing debt rather than becoming worthless, exactly as a firm’s stock is diluted by new share issues devoted to unproductive spending; a stable, determinate price level generally requires exactly one of the fiscal and monetary “legs” of policy to be active (destabilizing on its own) and the other passive (stabilizing), in Leeper’s (1991) terminology; and even the textbook-correct combination of active money with passive (“Ricardian”) fiscal policy typically admits additional, self-reinforcing explosive-inflation equilibria that no amount of monetary “credibility” can rule out – ruling them out requires a widely believed fiscal commitment to a floor value for the currency, a backstop that, once credible, need never actually be invoked. Sims extends the analysis to deflationary stress, showing (following Benhabib, Schmitt-Grohe, and Uribe 1998) that a liquidity trap can become a genuine equilibrium if fiscal policy is not correspondingly aggressive in cutting primary surpluses as prices fall, and illustrates with the U.S. in the 1930s, Mexico’s 1994-95 bank bailout, and Japan’s protracted banking-crisis deflation that central-bank actions to shore up a distressed banking system inevitably acquire a fiscal dimension, since they put public solvency at risk and may require legislative backing. He also shows that FTPL implies exchange rates are determined by the ratio of countries’ price levels, which are in turn set by their respective debt-to-surplus ratios, so that foreign-currency borrowing acts as leverage on a country’s exposure to fiscal-driven speculative attacks – a mechanism Sims connects to the Asian financial crises’ pattern of devaluation, financial distress, and government bailouts. Turning to EMU specifically, Sims argues the Maastricht fiscal criteria amount to a commitment that each member state individually follows a “passive” fiscal policy, which is necessary but insufficient for price stability, because ruling out the union-wide explosive-inflation equilibria requires a coordinated fiscal backstop that no single member state, especially a small one, can credibly provide alone – and because interest-rate uniformity across member states (if pursued) creates a “fiscal free-rider” incentive for any country to run an unbacked deficit and export its inflationary consequences to its EMU partners. He further shows that Maastricht’s passive fiscal rules would push policy in exactly the wrong direction during a deflationary depression, when what is needed is fiscal expansion rather than continued surplus-raising, though paradoxically the very free-riding the rules are meant to prevent could let one sufficiently expansive member country pull the whole union out of a liquidity trap. Sims closes by rejecting the alternative view that financial markets alone will discipline fiscally irresponsible EMU members, arguing that a country facing a self-reinforcing rise in its borrowing costs would likely exit the union and reclaim the option of inflationary finance rather than default, a dynamic that could threaten contagion across the currency area; he concludes that “fiscal institutions as yet unspecified will have to arise or be invented in order for EMU to be a long term success.”

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The Precarious Fiscal Foundations of EMU